What is Depletion Expense?

Definition: Depletion expense is the cost allocated to natural resources when they extracted. The concept of depletion of natural resources is similar to the depreciation of fixed assets. Since natural resources don’t have useful lives like fixed assets do, they can’t be depreciated over a certain period of time. Instead they are depleted as they are used or sold.

What Does Depletion Expense Mean?

What is the definition of depletion expense? Natural resources like oil, natural gas, and coal are drilled or mined from the ground. It’s impossible to accurately know how much resources are below the earth’s surface before they are extracted. That is why GAAP requires that natural resources be capitalized at cost initially. The purchase price or cost of the resources, mineral rights, and anything needed to prep the area for extraction is then allocated over the period of time they are consumed.

The depletion equation is somewhat different than a typical depreciation formula because you have to figure out an average price per unit first. To calculate the depletion per unit you take the total cost less salvage value and divide it by the total number of estimated units.

The expense is calculated by multiplying the depletion per unit by the number of units consumed or sold during the current period.

Let’s take a look at an example.

Example

Let’s take a look at an example. Big John Oil recently purchased an oil field in central Texas for $1 million. BJ estimates that there are 500,000 gallons of oil in the reserve on this property. Thus, the cost allocated to each gallon is two dollars. Over the course of the first year, BJ successfully drills and extracts 100,000 gallons of oil and sells it to his resellers and refineries. BJ would record $200,000 of depletion in the first year.

Every year after this, BJ will record a depletion expense until the full $1 million of cost is allocated to the asset.

Summary Definition

Define Depletion Expenses: Depletion expense means the cost incurred by a business when natural resources are extracted from their reserves.